Principles of Macroeconomics (ECO 102)

Chapter 2 Measuring a Nations Income

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THE ECONOMY S INCOME

One measure of standard of living:
goods and services consumed per person

Well-being of a person
health indicators environmental quality HDI: average of life expectancy index, education index and GDP per head

How do personal incomes and average income compare?

US since the 1980s: average income increases while income of the average household decreases

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THE ECONOMY S INCOME

What do we learn from total income?
total income that people in the economy as a whole are earning.

Growth/contraction in aggregate income:

how well the economy is doing is there demand in the labor (and other) market(s)?

Aggregate income measured as gross domestic product (GDP)

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THE ECONOMY S INCOME AND EXPENDITURE

GDP measures
Total income Total expenditure on THE ECONOMY s output

For an economy as a whole, income must equal expenditure because:

Every transaction in a market has a buyer and a seller. Every dollar of spending by some buyer is a dollar of income for some seller.

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Figure 1 The Circular-Flow Diagram

MARKETS Revenue FOR GOODS AND SERVICES Firms sell Goods Households buy and services sold

Spending Goods and services bought

FIRMS Produce and sell goods and services Hire and use factors of production

expenditures income

HOUSEHOLDS Buy and consume goods and services Own and sell factors of production

Factors of production Wages, rent, and profit

Labor, land, MARKETS and capital FOR FACTORS OF PRODUCTION Households sell Firms buy Income = Flow of inputs and outputs = Flow of dollars

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Copyright 2004 South-Western

THE MEASUREMENT OF GROSS DOMESTIC PRODUCT

GDP as a measure of income and expenditures:
Sum of total expenditures in product markets (top half of graph) Sum of total income from factor markets (bottom half of graph)

Total market value of all final goods and services produced within a country in a given period of time.
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Features of GDP
Output valued at market prices. Output of final goods
count production only once

Money one would need to purchase a year s worth of the economy s production.

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THE COMPONENTS OF GDP

GDP (Y) is the sum of the following expenditure categories:
Consumption (C) including sales taxes Investment (I) Government Purchases (G) Net Exports (NX)

Y = C + I + G + NX

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THE COMPONENTS OF GDP

Consumption (C):
The spending by households on goods and services, with the exception of purchases of new housing.

Investment (I):
The spending on capital equipment, inventories, and structures, including new housing.

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THE COMPONENTS OF GDP

Government Purchases (G):
The spending on goods and services by local, state, and federal governments. Does not include transfer payments because they are not made in exchange for currently produced goods or services.

Net Exports (NX):

Exports minus imports.

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How does government add to GDP?

purchases count as expenditures buys not exclusively from firms but also directly in factor market (for example, hiring teachers) whatever the government provides (such as government-provided education) is evaluated at expenditures necessary to provide it.
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Examples
Government builds and runs a new school
effect on GDP? what expenditure components are affected?

Buying a retirement home at home

effect on GDP? what is effect on expenditure components of GDP? what if retirement home is in Spain?

Import of a new car (entirely built abroad)

what is the effect on GDP what is the effect on exp. components of GDP?
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What is not in the GDP

GDP includes all items produced in the economy and sold legally in markets. This definition excludes:
Not in markets: Homeproduction, DIY Illicitly sold items, such as illegal drugs
however: Columbia

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so far
GDP measure goods and services produced income = expenditures on a nation s production using market prices fundamental equation:
Y = C + I + G + NX

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Table 1 Gross Domestic Product: components by expenditure category

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Copyright2004 South-Western

Table 2 Gross Domestic Product: Components by category of income

capital consumption allowance takes account of depreciation: wear and tear of the economys capital stock

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Copyright2004 South-Western

 Pech 2008

taken from Jeff Werlin (University of Maryland, 2005)

NNP versus GDP

C + I + G + NX = wages + profits + other income + tax + capital consumption allowance
Net National Product (NNP): Total income of residents of a nation after subtracting capital consumption allowance.

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Three More Measures of Income

National Income
NNP minus indirect business taxes such as sales taxes, minus statistical discrepancy Personal Income: The income that households and non-corporate businesses receive. Disposable Personal Income: The income that households and non-corporate businesses have left after taxes.
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what makes Americans reelect their president?

American National Election studies: are you better off or worse off than you were a year ago ? so has disposable income or GDP greater impact?

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GDP versus GNP

GNP is the total income earned by a nation s permanent residents (called nationals) at home or abroad
= GDP + Income earned by nationals abroad - Income earned by foreign nationals in the country

Ireland:

Gross Product GDP - per cap. GNP - per cap.

2003

2004

2005

2006

35,037 36,723 39,097 41,205 29,578 30,982 32,857 35,173

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REAL VERSUS NOMINAL GDP

If total spending rises from one year to the next, one of two things must be true
The economy is producing a larger output of goods and services Goods and services are being sold at higher prices

We want to measure the change in quantity of goods/services produced

evaluated at given prices

Nominal GDP values the production of goods and services at current prices. Real GDP values the production of goods and services at constant prices.
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The GDP Deflator

The GDP deflator is calculated as follows:

Nominal GDP GDP deflator = v 100 Real GDP

GDP deflator is measure of the price level rise in nominal GDP attributed to a rise in prices rather than a rise in quantity
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The GDP Deflator

Converting Nominal GDP to Real GDP
Nominal GDP is converted to real GDP as follows:

Real GDP2007

Nominal GDP2007 ! v 100 GDP deflator2007

Real GDP and deflator is defined for a particular base year (at the moment 2002 in the UK)
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Table 3 Real and Nominal GDP

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Copyright2004 South-Western

Table 3 Real and Nominal GDP

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Copyright2004 South-Western

Table 3 Real and Nominal GDP

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Copyright2004 South-Western

Human Development index

HDI, assembled by United Nations Human Development Report Office average of
life expectancy index education
adult literacy rate enrolment of potential students primary, secondary and teriary education

GDP per head at purchasing power parity $

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 Pech 2008